Index ETF: Cost Effective, Simple and Diversified

What if we tell you that there is an investment vehicle which is cost-effective, simple and diversified? Surprised? Well, index ETFs have slowly and steadily gained popularity among Indian investors over the past few years. Whether you are a seasoned investor or a beginner, understanding index ETFs will open your horizons to invest in a different type of fund from actively managed mutual funds.

This article will cover what index ETFs are, their types, advantages, how they work and the potential risks involved in investing in them.

• Table of contents

• Defining index ETF
• Index ETFs pros
• Types of index ETFs
• How does an index ETF work?
• Risks of index ETFs

Defining index ETF

An exchange-traded fund (ETF) is like a basket of securities that holds different investments, such as stocks, bonds and commodities. It works like a mutual fund but is traded on the stock exchange like a stock. ETFs track a benchmark index, regardless of market ups and downs. Meaning, an ETF tracking a specific benchmark will hold the exact same stocks in the same weight as the underlying benchmark.

One well-known ETF is the Nifty 50 ETF, which follows the Nifty 50 index.

ETFs are highly liquid, allowing investors to buy or sell units anytime during trading hours. India introduced ETFs in 2001, with NIFTY BEES being the first, based on the NIFTY 50 index.

Also Read: How To Invest in ETFs

Index ETFs pros

• Diversification: Index ETFs hold multiple stocks or bonds within a specific index, mitigating the impact of poor performance from a single asset.
• Lower costs: Since these ETFs follow a passive investment strategy, they typically have lower management fees compared to actively managed funds.
• Liquidity and flexibility: Unlike traditional mutual funds, which are priced at the end of the trading day, Index ETFs can be bought and sold throughout the day at market prices.
• Transparency: Investors can easily see which assets are included in the ETF since most fund providers regularly disclose their holdings.

Types of index ETFs

• Commodity ETFs: They invest in commodities like gold, silver, oil and agricultural products. You don’t own the actual asset but hold contracts backed by these commodities. Example – Nippon India ETF Gold BeES.
• Sector ETFs (Industry ETFs): They focus on specific industries like technology, energy or finance. These ETFs follow a classification system (GICS) that groups companies based on their industry type. Example – Nifty PSU Bank ETF.
• Bond ETFs: They invest in government bonds and other fixed-income securities. Example – Bharat Bond ETF.
• Currency ETFs: They allow you to invest in foreign currencies like the Euro or US Dollar. Example – Mirae Asset NYSE FANG+ ETF.
• Inverse ETFs: They are designed for short selling, meaning you profit when stock prices fall by selling high and buying back at a lower price. SEBI has not yet allowed direct inverse ETFs in India.
• Global index ETFs: They provide exposure to stock markets worldwide, including both developed and emerging markets, helping diversify investments.

How does an index ETF work?

• Asset selection: An ETF provider selects a mix of assets like stocks, bonds, commodities or currencies and creates a basket of investments.
• Shares for investors: Investors can buy shares of this basket, just like purchasing stock in a company.
• Trading on an exchange: ETFs are traded on the stock exchange throughout the day, with prices fluctuating based on demand, just like regular stocks.

Risks of index ETFs

• Market risk: Since Index ETFs track the overall market or sector, they are exposed to market fluctuations, which can lead to losses during downturns.
• Liquidity risk: Some specialised or niche Index ETFs may have lower trading volumes, leading to difficulties in buying or selling shares at favourable prices.
• Tracking error: ETFs aim to match the returns of an index, but factors like transaction costs, management fees and tracking methods can cause slight differences in performance. This difference is called a tracking error.

Also Read: What are Index Funds?

Conclusion

Index ETFs are a suitable investment option for those looking for diversification, cost efficiency, and ease of trading. They offer exposure to various markets with minimal management fees, making them a great choice for both new and experienced investors.
By holding an ETF, you automatically gain exposure to a range of assets, mitigating the risk that any single company’s underperformance will hinder your returns.

FAQs:

What is an Index ETF, and how does it work?

An index ETF is a type of fund that follows a specific market index and trades on the stock exchange. It holds a mix of assets that match the index, helping investors invest in the overall market performance.

What are the different types of index ETFs available?

Commodity ETFs, sector ETFs (industry ETFs), bond ETFs, currency ETFs, and global index ETFs

What are the key advantages of investing in index ETFs?

Index ETFs offer benefits such as diversification, lower costs, liquidity and flexibility, transparency

What risks should investors consider before investing in index ETFs?

Investors should be aware of market risk, tracking error, liquidity risk, tracking error and settlement dates when investing in index ETFs.

How do index ETFs compare to actively managed mutual funds?

Index ETFs generally have lower fees and greater transparency compared to actively managed mutual funds. However, actively managed funds may offer the potential for higher returns if managed well, whereas index ETFs passively track the market.